Hayley McDowell: Over the past year there have been periods of heightened volatility in fixed income. How have you managed trading activity in the context of these periods?
Nick Cox: Obviously we are long-term investors and we are not trying to capture intraday movements or daytime high/lows, so although there has been a pick-up in volatility over the past year, in some ways the increase in volume and turnover has effectively facilitated greater liquidity. With greater uncertainty there’s more two-way flow and those increased volumes have allowed us to move risk around more easily than when volatility is very low and markets are very quiet. It provides just not just alpha opportunities in terms of what the economic or political news is going to mean for the medium to long-term move in the market, but they provide liquidity windows to facilitate risk transfer at sensible transaction cost levels.
HM: How has the changing regulatory and business landscape affected liquidity for buy-siders?
NC: Looking back, I think there has been a change in liquidity particularly for products such as credit since 2008 when the increase in capital rules impacted the amount of inventory that sell-side firms can carry. But looking more recently, the liquidity situation probably hasn’t deteriorated much in the last three to four years. I believe we have hit a new normal level for now. The next big thing on the horizon is the introduction of MiFID II – particularly pre- and post-trade transparency regime – and the great unknown of what will actually be the impact on liquidity from that change. For the last few years, I would say we have been in a reasonable stable state of cost of liquidity.
From our perspective, the predictability of the cost of liquidity is one of the most challenging aspects. We factor transaction costs into all of our investments strategies, either implicitly or explicitly. Some of those costs enable you to have a good idea of whether you can capture alpha opportunities or whether the opportunity is not realisable because transaction costs outweigh the alpha. The challenge when transaction costs are volatile is, do you try and put an trade on, but it gets eaten away by the transaction cost or do you not put the trade on and miss out on an alpha opportunity? The uncertainty of transaction costs, rather than having an absolute level of transaction costs as being high or low, has been challenging at times.
HM: How do you think MiFID II will specifically affect liquidity for the buy-side?
NC: I think the biggest challenge for MiFID II is the pre-trade transparency. For post-trade, you have the precedent of TRACE in the US, although in Europe it will be somewhat more stringent. It’s a different version of something that the market more broadly has become familiar with. But pre-trade transparency is something that – as far as I’m aware – hasn’t been tried in any major market elsewhere. The concept of systematic internalisers and the transparency requirements of that regime too are also a great unknown. That may be a big challenge from a liquidity perspective because it hasn’t been really tested anywhere else. We don’t know what the impact will really be.
HM: Do you think buy-side-to-buy-side liquidity is a viable method of transacting trades? Or will the buy-side remain to be heavily reliant on dealers?
NC: Buy-side-to-buy-side liquidity is another tool in the box. If you think of every trade, there’s a certain frictional barrier that needs to be overcome for the trade to actually happen. What this method does is reduce that barrier for some trades. So, some trades do occur from buy-side-to-buy-side, which perhaps wouldn’t have happened from buy-side to broker-dealer kind of model. This could be due to the bandwidth of individuals or even relative cost benefits. It does help liquidity and it reduces – not necessarily the frictional costs of trading – but the theoretical potential barrier to a trade actually happening. However I don’t see buy-side-to-buy-side becoming the dominant paradigm any time soon, and particularly for material risk transfer type trades, the client-to-dealer paradigm will continue to dominate for some time to come.
HM: Can technology provide solutions for issues investors face in fixed income?
NC: Yes, just as with other aspects of our lives at home or at work, technology is changing how we behave and our function. I think when I look at the technological aspects of trading challenges, you could broadly put them into two categories. Firstly, liquid products – which is an execution challenge, so foreign exchange, futures and the very top end of core liquid rates markets – that’s about building efficient execution mechanisms. Both the buy-side and sell-side has come a long way in terms of building those platforms and protocols to address that challenge.
The other category is for less liquid products, which is about building a picture of liquidity and understanding where I can source bids or offers in the market. It’s about understanding where that liquidity resides and being able to build that picture swiftly and confidently. A number of initiatives shows the industry is starting to move into that space and I think that’s where we will start to see more of a transformation in terms of how markets operate. On top of that, the commercial pressures on the sell-side, the number of human brokers that are employed and justify having on a desk is clearly changing. Even with a pick-up of volatility, we don’t see that trend reversing. So it’s also about using data at the point of execution to understand where liquidity lies, and also feeding that back more fundamentally to the investment process.
HM: Which technology solutions does JP Morgan have in place already and which are you looking at implementing in the future?
NC: Historically, we have been biased towards vendor solutions but what we have done over the past few years is be a little more judicious about whether we buy something or build it ourselves. If the best product out there for the job or the function is a vendor solution, then we will buy it, but if the solution given our investment process is a proprietary one then we are now far more ready to build that solution rather than buy. A good example of that is our foreign exchange trading and order management platform that we’ve built out from scratch. The user interface and the logic around execution is something developed internally and very much proprietary, and then we use a vendor solution to deal with some of the connectivity at the back end. But that’s an area that in order to get a solution that is optimised towards our workflow, build is much than buy.
HM: What are your thoughts on the explosion of bond trading platforms that have entered the market in recent years?
NC: Inevitably with any kind of explosion of new ideas, some of those initiatives will wither on the vine, because they don’t present a strong enough, differentiating value proposition. To be better than what’s already out there in terms of the incumbents or the 120 other initiatives, maybe 10% will thrive because the ecosystem cannot support all of those competing products. It’s an explosion of life into an ecosystem that is unsustainable. More recently, the initiatives have been less about bringing another trading platform or novel trading paradigm but actually broader FinTech initiatives addressing various parts of the transaction lifecycle, data or market information. That’s where, more recently, we’ve seen initiatives launch that are looking at different parts of the value chain, rather than just being another trading platform.
HM: What differentiates JP Morgan’s platforms to its competitors?
NC: Obviously, we are substantial organisation in terms of size and scale and our breadth of activity in the fixed income space, from core macros rates to foreign exchange to high yield, is a significant differentiator. Our global reach. From Hong Kong, Tokyo to North America is another aspect. But also being an active manager is somewhat differentiating from our larger competitors who are dominated by passive products. As we discussed before, we do have the scale and size that we can invest in our own proprietary systems and as the economics of our business become evermore challenging for us and our competitors, having scale and being able to invest in your own technology will become an ever-increasing differentiator.